Speculation surrounds Sears' fate

It may seem far-fetched that a retailer as massive as Sears, Roebuck and Co. could ever be dismantled to tap the underlying value of its real estate.

After all, the Hoffman Estates-based company is an American icon. It has $9.5 billion in market value, $31 billion in 2003 merchandise sales and $2.7 billion in cash on hand to play with.

But on Nov. 5, when a voracious real estate outfit called Vornado Realty Trust revealed that it had quietly amassed control of 4.3 percent of the company's stock, it highlighted a fundamental shift in the way the market values retailers. The move puts heavy pressure on Sears Chairman Alan Lacy to justify the company's weak profits and outmoded merchandizing strategies.

According to interviews with retail and real estate experts, opportunistic investors like Vornado Chairman Steven Roth and Edward S. Lampert, who separately owns 15 percent of Sears stock, might be able to make more money by selling many of Sears' poorly performing but well-located stores to more successful retailers. And Sears itself might be more viable as a smaller chain with a tighter focus.

While Lacy is intent on making Sears grow, Roth or Lampert may see more profit in forcing it to shrink. Sears is unlikely to disappear altogether, but many experts believe this could catalyze a major restructuring.

"If you can make the retail company work, and unlock a lot of the value in the real estate at the same time, there's money to be made," said George Good, a senior vice president with real estate firm CB Richard Ellis Inc.

Lacy's inability to turn Sears around after four years of trying has run smack into a powerful real estate trend that has created heavy demand for just the kinds of properties that Sears has in abundance.

That's why Sears' stock soared 23 percent after the Vornado announcement on Nov. 5 and another 5 percent on Thursday when Robert Ulrich, chairman of Target Corp., told analysts his company is open to the idea of buying prime mall-based properties.

Over the last few years, new mall construction has slowed to a crawl, about 1 percent growth annually versus 5 percent a year in the 1980s. Growing retailers like Target and Nordstrom Inc. can't find enough space for new stores, especially in urban and suburban markets where property is at a premium.

Older, ailing retailers like Sears, Kmart Holding Corp. and Mervyn's LLC have lots of stores in attractive locations that might be used more profitably by some of these potent competitors. That has created a value vacuum that is beginning to make investors question whether sluggish stores could be sold for a rich profit.

"A retailer will keep an underperforming store open," said Louis Taylor, a real estate analyst at Deutsche Bank Securities Inc. in New York. "A real estate guy will say. `Hey, look, if you're doing $100 a square foot [in sales], I'll buy it from you and lease it to a tenant that's doing $300 to $400 a square foot.' Until now there's been no pressure on retailers to change."

Pressure started building on Lacy in 2002 when Lampert, the 42-year-old chairman of a Connecticut hedge fund called ESL Investments Inc., began collecting a 15 percent stake in the retailer. Lampert has so far been a passive voice among Sears' major shareholders. But he has proven already how hot the market is for recycled retail real estate by selling more than $1 billion worth of assets at Kmart.

Lampert took control of Kmart out of bankruptcy in early 2003 and began spinning out properties. Earlier this year, he sold 50 stores to Sears for $576 million and 18 others to Home Depot for $271 million. Some observers have questioned the wisdom of downsizing the huge retailer, but others note that Lampert has already raised more money than anyone else had thought possible.

"People are looking at what happened at Kmart and thinking, `Oh, my God!'" said one investor in similar deals who has worked closely with Sears. "A lot of people misunderstood the asset values. Lampert didn't."

Because Roth, Vornado's hard-nosed chairman, has also made a career out of acquiring distressed real estate and spinning it into gold, few industry experts expect him to sit still. Neither Roth nor Lampert have signaled their intentions regarding Sears, and both declined requests for comment for this article. But they are known as aggressive investors, and together their investments represent almost 20 percent of Sears' stock. That alone would give them a firm platform from which to pressure Lacy together if they chose.

Lacy also declined a request for an interview. A Sears spokesman issued a statement saying, "We are pleased that Vornado sees value in our stock." In late October, Sears shares were down 29 percent from a year earlier.

A source close to the board said Lampert "has been very supportive of what Alan has been doing." The source added that the board is not yet aware of whether ESL is working with Vornado, or what their plans are.

Mervyn's deal offers hints

Vornado's intentions, however, may be revealed by a deal it didn't do: the $1.2 billion purchase of Mervyn's, a 257-department store chain based in Hayward, Calif., that was previously owned by Target. Vornado was outbid by a group that included Florida retail investment firm Sun Capital Partners Inc., New York hedge fund Cerberus Capital Management LP, and a joint venture of Chicago's Klaff Realty LP and Philadelphia-based investment fund Lubert-Adler Management Inc.

Mervyn's, with a real estate portfolio of more than 20 million square feet, is less than one-seventh the size of Sears. But common strategies may be at work in both deals, say investors who specialize in buying and reselling sluggish retail stores.

Like Sears, Mervyn's had struggled for years to find a lucrative place in a retail environment increasingly dominated by discounters and high-concept specialty stores. While the Sun group plans keep the chain open, one executive familiar with the group's strategy said it will evaluate every store individually to decide whether it would generate more profit to operate the store or to sell the underlying real estate. The group is already considering spinning off 40 of the stores to J.C. Penney Co., according to published reports.

A typical analysis would work this way: Suppose Mervyn's has an 80,000-square-foot store on a prime corner in the San Francisco Bay area that pulls in a profit of around $2 million a year. Over 10 years that would add up to $20 million in profits for the store's investors. But in some cases, a major reason for that profit is that Mervyn's has an especially low occupancy cost because it built or leased the store years ago when a mall owner wanted to lure it in as a tenant. In that kind of scenario, the store could make money, even though Mervyn's average sales of $165 a square foot lag the industry.

For a traditional retailer, the analysis would end there and the store would stay open. But an investor like Roth or Lampert would measure the store's value more rigorously.

If the site was attractive enough, a rival retailer with sales per square foot of $250 or $300 would likely be willing to pay a much higher lease rate, sometimes 50 percent or more. That presents an opportunity to sublease the space or negotiate a deal under which the mall owner would pay Mervyn's to buy out the lease. If that creates a profit in excess of the $20 million investors would earn from keeping the store open, then it probably makes sense to take the cash and close the store.

At the same time, preserving Mervyn's as an operating company serves two purposes. Stores that are profitable enough to be kept open can be packaged into a new company, fixed up and resold later. More important, if a store buyer thought Mervyn's was liquidating, it would reduce the seller's leverage in any negotiation.

This is an oversimplification of the strategy. There are all sorts of other considerations that go into the calculation, from common area maintenance charges to closure costs to the net effect on the chain's distribution system. But in the end it comes down to this question: If you keep the store open--even a profitable one--are you missing the chance to sell it for an even greater profit?

Sears, of course, would be much more difficult to analyze and restructure than Mervyn's. Sears has more than 141 million square feet of retail space, according to its annual report. It owns almost 60 percent of its 871 full-line stores, which are primarily located in large shopping centers. Those stores alone total 128 million square feet. Sears also has 345 specialty stores, including 245 hardware stores and 18 focused on home decorating and remodeling.

But the real estate Sears owns is uniquely valuable in several respects. First, analysts say, many of its stores are in prime locations that have become congested over the years. The sites are often next to desirable corners and have special features like big parking lots with easy access from the street. They are also big enough to split. A Sears store at SouthPark Mall in Charlotte, for instance, is being redeveloped by Simon Property Group Inc. into a Dick's Sporting Goods Inc. and a Joseph Beth Booksellers.

One key is that Sears' lease and ownership costs are low. According to Deutsche Bank's Taylor, Sears' average rent is about $2 a square foot, versus $7.49 for Kohl's or $5.21 for Nordstrom. That helps it afford sales per gross square foot that average $179 in its department stores versus $225 at the average Target discount store or $345 at Nordstrom, Taylor said.

Both men familiar with Sears

While all of this provides a road map to better profits, it is less clear how Roth or Lampert might persuade Sears to begin the journey. Several observers of both men, however, expect they are unlikely to stay passive investors for long. Lampert, for instance, has been highly active in all aspects of the Kmart investment, from dealmaking to fixing the stores.

As far as Roth is concerned, Stephen G. Tomlinson, a partner with Chicago-based law firm Kirkland & Ellis LLP, thinks the investor has two possible strategies. Vornado could agitate for shareholders to force Lacy to re-evaluate his stores. If that fails, Roth could battle for outright control, a more costly, time-consuming effort.

Vornado certainly knows Sears well. Its president, Michael Fascitelli, advised the company as an investment banker for Goldman Sachs Group Inc. when Sears sold its Homart real estate unit for $2.3 billion in 1995.

Investment bankers in the business insist that Roth and Lampert could attract financing for a buyout, especially if they acted together. It helps that their mere presence has added $1.8 billion to Sears' market value over the last week. The two have probably already caught the imagination of other Sears investors, putting the onus on Lacy to explain why spinning off real estate isn't a good idea.

Tomlinson sums up the situation this way: "Every institution that holds Sears is thinking, `Well, gee, these guys are really smart in the real estate business and think this should happen. Shouldn't I think this should happen?'"